Letters of credit: landlords and lenders rejoice – Crystalline prevails

Based on basic principles of letters of credit and parties’ intentions (reflected in the specific lease and letter of credit language), the Ontario Court of Appeal confirms that a letter of credit is not rendered unenforceable by a landlord or limited to three months’ rent as a result of a disclaimer of the lease, i.e., rights against third parties relating to a lease survive. 

In May 2020, we published a legal update that provided a general overview on tenant insolvency issues for commercial landlords in Alberta. In the context of our general recommendations relating to letters of credit issued by third-party lenders as security for a tenant’s obligations under a lease, we noted an Ontario Superior Court of Justice decision, 7636156 Canada Inc. v OMERS Realty Corporation, which was subsequently appealed. On October 28, 2020, the Ontario Court of Appeal (the Court) released its decision,¹ which is the subject of this legal update.

Case facts and motion judge decision

Following the assignment in bankruptcy of 7636156 Canada Inc. (the tenant), OMERS Realty Corporation (the landlord) made a demand to draw on the $2.5 million letter of credit (the LOC) issued by a bank. The lease between the tenant and the landlord stipulated that the LOC would continue to stand as security should a disclaimer of the lease in connection with any bankruptcy of the tenant occur. Under its terms, if the lease is disclaimed in connection with any bankruptcy of the tenant, then the landlord could draw a portion or all of the LOC amount. 

The trustee in bankruptcy over the tenant brought a motion to disallow the draws made by the landlord, and the motion judge limited the recovery by the landlord under the LOC to the landlord’s preferred claim for three months’ accelerated rent under federal bankruptcy legislation. The motion judge relied on the Cummer-Yonge Investments Ltd. v Fagot (Cummer-Yonge) decision and reasoned that a disclaimer of a lease by a trustee in bankruptcy extinguishes all obligations of a tenant under a lease (including the third-party obligations and those being secured by a letter of credit).

Court of Appeal key conclusions 

The Court unanimously overturned the motion judge’s decision, holding that the motion judge erred in its findings. The Court confirmed the landlord was entitled to draw on the full amount of the LOC obtained under the lease with the bankrupt tenant instead of being limited to its preferred claim of three months’ worth of accelerated rent under bankruptcy legislation. The Court’s key conclusions are as follows:

• The Supreme Court of Canada in Crystalline Investments Ltd. v Domgroup Ltd. (Crystalline) overturned the Cummer-Yonge decision (on which the motion judge relied) and found that disclaimer alone does not relieve an assignor or guarantor from contractual obligations (i.e., a guarantor can still be liable for its obligations of the tenant in a lease even after the trustee disclaims the lease). The Court noted the ongoing question – whether the survival of a landlord’s claim against assignors and guarantors applies equally to claims by landlords on letters of credit issued by financial institutions at the tenant’s request. Based on the Court’s review of the case law, the Court affirmed that Crystalline not only allows third-party obligations, such as those of an assignor or a guarantor, to survive the disclaimer of a lease but this reasoning also extends to letters of credit. 
• The motion judge’s findings were contrary to basic principles relating to letters of credit. Subject only to the fraud exception, the autonomy principle for letters of credit means the issuing bank’s obligations are independent of the performance of the underlying lease for which such credit was created. The Court determined that the landlord made its demands under the LOC in conformity with its terms. The fundamental characteristic of a standby letter of credit is its autonomous nature. The fraud exception to the principle of autonomy applies in cases involving extreme acts of dishonesty or deceit by the beneficiary, noting an issuing bank has no duty to satisfy itself by independent inquiry that the beneficiary has not engaged in such fraud. 
• The lease and LOC terms clearly gave the landlord a right to draw on the LOC for losses arising from the disclaimer of the lease in the tenant’s bankruptcy proceeding. The Court concluded that the specific language of the lease and the LOC reflected the parties’ intention and a landlord’s entitlement to draw on a letter of credit despite the tenant’s bankruptcy. 

For a general overview on tenant insolvency issues for commercial landlords, please see our legal update.